1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-1 The management of financial institutions (Chapter 17) In this chapter, we examine how banking is conducted to earn the highest profits possible. Topics include: – The Bank Balance Sheet – General Principles of Bank Management – Measuring Bank Performance

2. Exercise ItalianEnglish Assegno Emettere assegni Prelevare Versare Filiale Prelevamento Conto corrente Depositi a risparmio Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-2

3. Exercise ItalianEnglish AssegnoCheck Emettere assegniTo write checks PrelevareTo withdraw VersareTo deposit FilialeBranch PrelevamentoWithdrawal Conto correnteCurrent account or Checkable deposit Depositi a risparmioSavings accounts Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-3

4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-4 The Bank Balance Sheet The Balance Sheet is a list of a bank’s assets and liabilities Total assets = total liabilities + capital

5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-5 The Bank Balance Sheet A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets) Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers

6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-6 The Bank Balance Sheet The next slide shows the aggregate balance sheet for all U.S. commercial banks. We will then step through each item, discussing each in detail.

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-7 Flow of funds (tab down to commercial banks) http://www.federalreserve.gov/releases/z1/ current/z1r-4.pdf http://www.federalreserve.gov/releases/z1/ current/z1r-4.pdf The Bank Balance Sheet

8. The next slide shows the aggregate balance sheet for all Italian banks (end of 2008). Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-8

9. The Bank Balance Sheet Assets%Liabilities% Cash items0,05Deposits from residents 50,5 Securities5,8Deposits from non-residents 17,8 Loans55,8Interbank borrowings 23,1 Interbank loans22,5Bank capital8,6 Equity stakes4,7 Foreign activities11,5 Total100Total100 Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-9

10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-10 The Bank Balance Sheet: Liabilities (a) Checkable Deposits: includes all accounts that allow the owner (depositor) to write checks to third parties; Checkable deposits are payable on demand: if a depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor immediately.

11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-11 The Bank Balance Sheet: Liabilities (a) Checkable deposits are usually the bank’s lowest cost funds because depositors want safety and liquidity and will accept a lesser interest return from the bank in order to achieve such attributes.

12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-12 The Bank Balance Sheet: Liabilities (b) Nontransaction Deposits: are accounts from which the depositor cannot write checks; examples include savings accounts and time deposits (also known as CDs or certificates of deposit) Saving accounts: funds can be added or withdrawn at any time, transactions and interest payments are recorded in a passbook held by the owner of the account

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-13 The Bank Balance Sheet: Liabilities (b) Time deposits have a fixed maturity length and asses substantial penalties for early withdrawal Nontransaction deposits are generally a bank’s highest cost funds because banks want deposits which are more stable and predictable and will pay more to the depositors (funds suppliers) in order to achieve such attributes.

14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-14 The Bank Balance Sheet: Liabilities (c) Borrowings: banks obtain funds by borrowing from the Federal Reserve System, other banks, their parent companies (bank holding companies)…;

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-15 The Bank Balance Sheet: Liabilities (d) Bank Capital: is the source of funds supplied by the bank owners, either directly through purchase of ownership shares or indirectly through retention of earnings (retained earnings being the portion of funds which are earned as profits but not paid out as ownership dividends). This is about 8/9% of assets.

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-16 The Bank Balance Sheet: Liabilities (d) Since assets minus liabilities equals capital, capital is seen as protecting the liability suppliers from asset devaluations or write- offs (capital is also called the balance sheet’s “shock absorber,” thus capital levels are important).

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-17 The Bank Balance Sheet: Assets (a) Reserves: funds held in account with the Fed (vault cash as well). Required reserves represent what is required by law under current required reserve ratios (the bank is obliged to keep a certain fraction of its deposits as required reserves). Any reserves beyond this area are called excess reserves (the most liquid of all bank assets).

18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-18 The Bank Balance Sheet: Assets (b) Securities: these are either U.S. government/agency debt, municipal debt, and other (non-equity) securities. (Banks in U.S. are not allowed to hold stock) Short-term Treasury debt is often referred to as secondary reserves because of its high liquidity.

19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-19 The Bank Balance Sheet: Assets (c) Loans: these are a bank’s income-earning assets, such as business loans, auto loans, and mortgages. These are generally not very liquid. Most banks tend to specialize in either consumer loans or business loans, and even take that as far as loans to specific groups (such as a particular industry).

20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-20 The Bank Balance Sheet: Assets (d) Other Assets: bank buildings, computer systems, and other equipment.

21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-21 General Principles of Bank Management Now let’s look at how a bank manages its assets and liabilities. The bank has four primary concerns: 1.Liquidity management 2.Asset management – Managing credit risk – Managing interest-rate risk 3.Liability management 4.Managing capital adequacy

22. Liquidity management The first concern is to make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows Reserves pay no interest, but… We assume that the bank has ample excess reserves and that all deposits have the same required reserve ratio of 10% Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-22

23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-23 Principles of Bank Management

24. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-24 Principles of Bank Management If a deposit outflow of $10 million occurs… With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

25. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-25 Liquidity Management With 10% reserve requirement, bank has $9 million reserve shortfall. To eliminate it the bank has different basic options

26. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-26 Liquidity Management

27. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-27 Liquidity Management Calling in loans: not renewing some loans when they come due

28. Liquidity Management Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows It explains why banks hold excess reserves even though loans or securities earn a higher return Copyright © 2009 Pearson Prentice Hall. All rights reserved. 17-28